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Summary (and Extension!) of My Post-CPI Tweets
Below you can find a recap and extension of my post-CPI tweets. You can follow me @inflation_guy or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments.
- CPI -0.7%, core +0.2%. Ignore headline. Annual revisions as well.
- Core +0.18% to two decimals. Strong report compared to expectations.
- Core rise also off upwardly-revised prior mo. Changing seasonal adj doesn’t affect y/y but makes the near-term contour less negative.
- y/y core 1.64%, barely staying at 1.6% on a rounded basis.
- Core for last 4 months now 0.18, 0.08, 0.10, 0.18. The core flirting with zero never made a lot of sense.
- Primary rents 3.40% from 3.38% y/y, Owners’ Equiv to 2.64% from 2.61%. Small moves, right direction.
- Overall Housing CPI fell to 2.27% from 2.52%, as a result of huge drop in Household Energy from 2.53% to -0.06%. Focus on the core part!
- RT @boes_: As always you have to be following @inflation_guy on CPI day >>Thanks!
- A bit surprising is that Apparel y/y rose to -1.41% from -1.99%. I thought dollar strength would keep crushing Apparel.
- Also New & Used Motor Vehicles -0.78% from -0.89%. Also expected weakness there from US$ strength. Interesting.
- Airline fares, recently a big source of weakness, now -2.98% y/y from -4.71% y/y.
- 10y BEI up 4bps at the moment. And big extension tomorrow. Ouch, would hate to have bet wrong this morning.
- Medical Care 2.64% y/y from 2.96%.
- College tuition and fees 3.64% from 3.43%. Child care and nursery school 3.05% from 2.24%. They get you both ends.
- Core CPI ex-[shelter] rose to 0.72% from 0.69%. Still near an 11-year low.
- Overall, core services +2.5% (was +2.4%), core goods -0.8% (was -0.8%). The downward pressure on core is all from goods side.
- …and goods inflation tends to be mean-reverting. It hasn’t reverted yet, and with a strong dollar it will take longer, but it will.
- That’s why you can make book on core inflation rising.
- At 2.64% y/y, OER is still tracking well below our model. It will continue to be a source of upward pressure this year.
- Thank you for all the follows and re-tweets!
- Summary: CPI & the assoc. revisions eases the appearance that core was getting wobbly. Median has been strong. Core will get there.
- Our “inflation angst” index rose above 1.5% for the 1st time since 2011. The index measures how much higher inflation FEELS than it IS.
- That’s surprising, and it’s partly driven by increasing volatility in the inflation subcomponents. Volatility feels like inflation.
- RT @czwalsh: @inflation_guy @boes_ using surveys? >>no. Surveys do a poor job on inflation. See why here: http://www.palgrave-journals.com/be/journal/v47/n1/abs/be201135a.html …
- 10y BEI now up 5.25bps. 1y infl swaps +28bps. Hated days like this when I made these markets. Not as bad from this side.
- Incidentally, none of this changes the Fed outlook. Median was already at target, so the Fed’s focus on core is just a way to ignore it.
- Once core rises enough, they will find some other reason to not worry about inflation. Fed isn’t moving rates far any time soon.
- Median CPI +0.2%. Actually slightly less, keeping the y/y at 2.2%.
What a busy and interesting CPI day. For some months, the inflation figures have been confounding as core inflation (as always, we ignore headline inflation when we are looking at trends) has consistently stayed far away from better measures of the central tendency of inflation. The chart below (source: Bloomberg), some version of which I have run quite a bit in the past, illustrates the difference between median CPI (on top), core CPI (in the middle), and core PCE (the Fed’s favorite, on the bottom).
I often say that median is a “better measure of central tendency,” but I haven’t ever illustrated graphically why that’s the case. The following chart (source: Enduring Investments) isn’t exactly correct, but I have removed all of the food and beverages group and the main places that energy appears (motor fuel, household energy). We are left with about 70% of the index, about a third of which sports year-on-year changes of between 2.5% and 3.0%. Do you see the long tail to the left? That is the cause of the difference between core and median. About 12% of CPI, or about one-sixth of core, is deflating. And, since core is an average, that brings the average down a lot. Do you want to guide monetary policy on the basis of that 12%, or rather by the middle of the distribution? That’s not a trick question, unless you are a member of the FOMC.
Now, let’s talk about the dollar a bit, since in my tweets I mentioned apparel and autos. Ordinarily, the connection between the dollar and inflation is very weak, and very lagged. Only for terribly large movements in the dollar would you expect to see much movement in core inflation. This is partly because the US is still a relatively closed economy compared to many other smaller economies. The recent meme that the dollar’s modest rally to this point would impress core deflation on us is just so much nonsense.
However, there are components that are sensitive to the dollar. Apparel is chief among them, mainly because very little of the apparel that we consume is actually produced in the US. It’s a very clean category in that sense. Also, we import a lot of autos from both Europe and Asia, and they compete heavily with domestic auto manufacturers. As a consequence, the connection between these categories and the dollar is much better. The chart below shows a (strange) index of New Cars + Apparel, compared to the 2-year change in the broad trade-weighted dollar, lagged by 1 year – which essentially means that the dollar change is ‘centered’ on the change in New Cars + Apparel in such a way that it is really a 6-month lag between the dollar and these items.
It’s not a day-trading model, but it helps explain why these categories are seeing weakness and probably will see weakness for a while longer. And guess what: those categories account for around 7% of the “tail” in that chart above. Ergo, core will likely stay below median for a while, although I think both will resume upward movement soon.
One of the reasons I believe the upward movement will continue soon is that housing continues to be pulled higher. The chart below (source: Enduring Investments using Bloomberg data) shows a coarse way of relating various housing price indicators to the owners’ rent component of CPI.
We have a more-elegant model, but this makes the point sufficiently: OER is still below where it ought to be given the movement in housing prices. And shelter is a big part of the core CPI. If shelter prices keep accelerating, it is very hard for core (and median) inflation to decline very much.
One final chart (source Enduring Investments), relating to my comment that our inflation angst index has just popped higher.
This index is driven mainly by two things: the volatility of the various price changes we experience, and the dispersion of the price changes we experience. The distribution-of-price-changes chart above shows the large dispersion, which actually increased this month. Cognitively, we tend to overlook “good” price changes (declines, or smaller advances) and recall more easily the “bad”, “painful” price changes. Also, we tend to encode rapid up-and-down changes in prices as inflation, even if prices aren’t actually going anywhere much. I reference my original paper on the subject above, which explains the use of the lambda. What is interesting is the possibility that the extremely low levels of inflation concern that we have seen over the last couple of years may be changing. If it does, then wage pressures will tend to follow price pressures more quickly than they might otherwise.
Thanks for all the reads and follows today. I welcome all feedback!
The Answer is No
What a shock! The Federal Reserve as currently constituted is dovish!
It has really amazed me in recent months to see the great confidence exuded by Wall Street economists who were predicting the Fed will begin tightening by mid-year. While a tightening of policy is desperately needed – and indeed, an actual tightening of policy rather than a rate-hike, which would do many bad things but not much good – I was surprised to see economists buying the line being put out by Fed speakers on this (and I took issue with it, just last week).
Yes, the Fed would like us to believe that they stand sentinel over the possibility of overstaying their welcome. Their speeches endeavor to give this impression. But it is easy to say such a thing, and to believe that it should be said, and a different thing altogether to actually do it. Given that the Fed’s “preferred” inflation measure is foundering; market-based measures of inflation expectations were in steady decline until mid-January; the dollar is very strong and global economic growth quite weak; and other central banks uniformly loose, in my view it seemed that it would have required a historically hawkish Federal Reserve to stay the course on a mid-year hiking of rates. Something on the order of a Volcker Fed.
Which this ain’t.
Today the minutes from the end-of-January FOMC meeting were released and they were decidedly unconvincing when it comes to steaming full-ahead towards tightening policy. There was a fairly lengthy discussion of the “sizable decline in market-based measures of inflation compensation that had been observed over the past year and continued over the intermeeting period.” The minutes noted that “Participants generally agreed that the behavior of market-based measures of inflation compensation needed to be monitored closely.”
This is a short-term issue. 10-year breakevens bottomed in mid-January, and are nearly 25bps off the lows (see chart, source Bloomberg).
To be sure, much of this reflects the rebound in energy quotes; 5-year implied core inflation is still only 1.54%, which is far too low. But we are unlikely to see those lows in breakevens again. Within a couple of months, 10-year breakevens will be back above 2% (versus 1.72% now). But this isn’t really the point at the moment; the point is that we shouldn’t be surprised that a dovish FOMC takes note of sharp declines in inflation expectations and uses it as an excuse to walk back the tightening chatter.
The minutes also focused on core inflation:
“Several participants saw the continuing weakness of core inflation measures as a concern. In addition, a few participants suggested that the weakness of nominal wage growth indicated that core and headline inflation could take longer to return to 2 percent than the Committee anticipated.”
As I have pointed out on numerous occasions, core inflation is simply the wrong way to measure the central tendency of inflation right now. It isn’t that median inflation is just higher, it’s that it is better in that it marginalizes the outliers. As I pointed out in the article last Thursday, Dallas Fed President Fisher seemed to be humming this tune as well, by focusing on “trimmed-mean.” In short, ex-energy inflation hasn’t been experiencing “continuing weakness.” Median inflation is near the highs. Core has been dragged down by Apparel, Education and Communication, and New and used motor vehicles, and these (specifically the information processing part of Education and Communication, not the College Tuition part!) are among the categories most impacted by dollar strength. Unless you expect dramatic further dollar strengthening – and remember, one year ago there were still many people who were bracing for a dollar plunge – you can’t count on these categories continuing to drag down core CPI.
Again, this isn’t the current point. Whether or not core inflation heads higher from here to converge with median inflation (which I expect to head higher as well), and whether or not inflation expectations rise as I am fairly confident they will do over the next few months, the question was whether a Fed looking at this data was likely to be gung-ho to tighten policy in the near-term. The answer was no. The answer is no. And until that data changes in the direction I expect it to, the answer will be no.
Downside for Stocks, But Also for Fed Expectations
Retail Sales figures today were weak. Retail Sales ex-Auto and Gas (I usually just look ex-auto, but then they look really, really bad because of how far gasoline has moved) just recorded the two worst numbers (0.0% and 0.2%) in a year.
Retail sales are volatile, so one shouldn’t get too exercised by a couple of weak figures. Except for the fact that we also know that overseas sales are going to be suffering, thanks to the strength of the dollar. The disinflationary tendency imparted by a strengthening dollar is mild, and takes some time to be evident in the figures. However, the effect on overseas sales tends to be more rapid, and the effect on earnings more or less instantaneous (because earnings need to be translated back into the reporting currency).
So it isn’t just the weakness retail sales that should give an investor pause here. It is difficult to sell stocks in an environment of abundant liquidity, but perhaps this chart (Source: www.Yardeni.com) is one reason to do so.
I am not a fan of Yardeni’s analysis, as a general rule, but this is a great chart package showing the evolution of earnings estimates over time.
I understand that we have become conditioned to buy stocks on every dip, especially when the world’s central banks continue to supply boundless money to the system – an approach which, miraculously, seems to have no downside (leaving us to wonder how much better off the poor benighted peoples of last century would have been if central banks had only discovered this elixir earlier). And I am no bolder than the rest of you, so I won’t short stocks either.
But explain to me why the Fed is going to tighten? Headline inflation is low; core PCE inflation is low; even the measure that Dallas Fed President Fisher prefers (Trimmed-Mean PCE) is low. I have pointed out how the better measure, Median CPI, is actually near the post-crisis highs and is right around the Fed’s target, but if we are taking a vote then I lose. Market-based inflation expectations have recently rebounded, and will continue to do so, but remain very low. Growth appears to be weakening, although not yet alarmingly so. Finally, foreign central banks are all easing, which is one big reason the dollar has risen as it has. I have difficulty with the idea that with all of these arguments, the Federal Reserve is going to choose now to pull back on the reins, simply because they have sorta hinted about it previously.
Incidentally, any impact on growth from the strike over the coming long weekend at West Coast ports won’t help the argument to ease. Nor will the ongoing strike at nine US oil refineries (the biggest strike of oil workers since 1980). For all of these reasons, I don’t think the Fed is going to tighten any time soon. I do believe that US stocks are rich compared to European stocks for example, and rich on an absolute basis, but if I were going to play the short side because of the earnings estimates revisions, I would do so with options.
Winter Is Coming
Sometimes being a value investor, amid overvalued (and ever more so) markets, feels a bit like being a Stark in Westeros. The analogy will be lost on you if you do not follow Game of Thrones, but the Starks hold the largest of the sub-kingdoms in Westeros. This kingdom also happens to be the coldest, and the sober Starks are always reminding people that “Winter is coming.”
I should observe that winter in Westeros is a much more serious affair than it is around here; it comes at odd intervals but can last for years. So being prepared for winter is really important. However, getting people to prepare for winter during the long “summer” is very difficult.
Sound familiar? The thing to keep in mind is that the Starks are always right, eventually, and they’re the ones who come through the winter in the best shape. Such is the case with value investors. (Some people might prefer calling value investors who are bearish on stocks right now “Chicken Littles” but I prefer being compared to Ned Stark, thanks. Although both of them have been known to lose their heads on occasion.)
Fortunately, it does not appear that winter is coming to the U.S. very soon. Friday’s Employment report was strong, despite the beginnings of downsizing in the oil and gas extraction businesses. The chart below shows the Baker Hughes oil and gas rig count, which is falling at a rate every bit as fast as it did in the credit crisis.
Yet, the U.S. economy as a whole generated 267,000 new jobs last month, which was above expectations. It is unlikely that this pace will continue, since the extraction (and related industry) jobs will be a drag. But in 2008, this happened when every other industry was being squeezed, and in the current case other industries are being squeezed by the strong dollar, but only mildly so. I think this will actually serve to increase the labor force participation rate, which has been in a downtrend for a long time – because laid-off oil workers will still be in the labor force looking for work, while other jobs will be getting filled by (sometimes) discouraged workers coming off the sidelines. So we may well see the Unemployment Rate rise even as jobs growth remains reasonable, even if less robust than the most recent figures.
Winter, though, is still coming.
In the near-term, winter is coming to Europe. Unusually, it is moving from the south to the north because Greece appears to be finally heading for the denouement that has been utterly unavoidable from the beginning. I wrote this in June 2012 (and I wasn’t the only one saying such things – the only real question has been how long it would take before the Greeks decided they’d had enough of sacrifice to hold together the Eurozone for the elites):
Greece will still leave the Euro. Government or no government, austerity or no austerity – the fiscal math simply doesn’t make sense unless Europe wants to pay for Greece forever. In principle, the Greeks can dig themselves out of trouble if they work harder, retire later, pay more taxes, and receive fewer government services. I do believe that people can change, and a society can change, under pressure of crisis. Remember Rosie the Riveter? But the question is whether they can change, whether they will change, do they even want to change, if the benefit of the change flows not to Greece’s people but to the behemoth European institutions that have lent money to Greece?
If a person declares bankruptcy, and the judge declares that he must pay all of his wages for the next thirty years, after deducting enough for food and shelter, to the creditors…do you think that person is going to go looking for a 60-hour workweek?
Am I sure that Greece is going to leave the Euro in a week, or a month, or a year? Not at all. The institutional self-preservation meme is very strong and I am always amazed at how long it takes obvious imperatives to actually happen.[1] But I am quite confident that Greece will eventually leave the Euro, and it does seem as if parties on all sides of the negotiating table are coming to that conclusion as well.
One question that authorities have had to come to peace with first was whether Grexit is really Armageddon. I have argued that default and an exit from the Euro is not bad for Greece, at least when compared to a multi-year depression.
And it’s probably not even horrible for Europe, or the world at large, at least compared to the credit crisis, despite all protestations that this would be “Lehman squared.” Again, this is old news and as I lay out the reasoning here there is no reason to repeat myself.
But it won’t be a positive thing. And it is likely to bring on “winter,” economically. Helpfully, the world’s central banks not only remain in easing mode but are increasing the dovishness of their stance, with the ECB foremost among the central banks that are priming the pumps again. M2 money growth in the Eurozone was up to 4.5% y/y in December (latest data available), with the highest quarter-over-quarter growth rate (8.3%, annualized) in money since the end of 2008! Meanwhile the Fed, while it is no longer adding to reserves, is still watching the money supply grow at 6% y/y with no good way to stop it. For all the talk about the FOMC hiking rates by mid-year, I think the probable rise in the Unemployment Rate discussed above, plus the weak inflation readings (with the notable exception of Median CPI), plus the fact that all other central banks are easing and likely to continue doing so, plus the probability of turbulence in Europe, makes it very unlikely that this Committee, with a very dovish makeup, will be tightening any time soon.
The likely onset of some winter will not help hold down inflation, however. Upward pressures remain, and the fact that the ECB is now running the pumps makes higher prices more likely. Yes, we care about money supply growth in Europe: the chart below shows the M2 growth of the US and Europe combined, against core CPI in the US. The fit is actually better than with US CPI alone.
Now, some markets are priced for winter and some are not. We think that real interest rates in Europe are far too low compared to real rates in the US, and stock prices in the US are too high compared to stock prices in Europe. The first chart below shows the spread of 10-year real rates in the US minus Europe (showing US yields are high compared to European yields); the second chart shows the ratio of the S&P 500 to the Eurostoxx 50.
You can see in the latter chart that the out-performance of the S&P has proceeded since 2009, while the under-performance of US inflation-linked bonds has only happened since 2012, so these are not simply two ways of looking at the same trade. In both cases, these deviations are quite extreme. But the European economy and the US economy are not completely independent of one another; weak European growth affects US corporate entities and vice-versa, and as I suggest above the growth of European money supply tends to affect US inflation as well. We think that (institutional) investors should buy TIPS and sell European linkers, and also buy European stocks against US stocks. By doing both of these things, the exposure to currency flows or general trends in global equity market pricing is lessened. (Institutional investors interested in how we would weight such a trade should contact us.)
[1] As another example, take the shrinking of Wall Street. It was obvious after 2008 that it had to happen; only recently, however, as banks and dealers have been forced to become more and more like utilities have we started to see layoffs while stocks are rising, which is very unusual. But Wall Street defended the bloated structures of the past for more than six years!
The F9 Problem
All around the world, investors and traders and even fancy hedge-fund guys are dealing with something that denizens of the inflation-linked bond world have been dealing with for some time.
I call it the F9 problem. Please come with me as I descend into geekdom.
You would be surprised to learn how many of the world’s major traders of bonds and derivatives rely for a significant amount of their analysis on the infrastructure of Microsoft Excel. While many major dealers have sophisticated calculation engines and desktop applications, nothing has yet been designed that offers the flexibility and transparency of Excel for designing real-time analytical functions on the fly. Bloomberg and other data providers have also built add-ins for Excel such that a subscriber can pull in real-time data into these customized calculation tools, which means that an Excel-based platform can be used to manage real-time trading.
When I have taught bond math, or programs like inflation modeling at the New York Society of Securities Analysts, I have had students design spreadsheets that built yield curves, calculated duration and convexity, valued vanilla derivative products, and so on. There are few better ways to learn the nuts and bolts of bond math than to build a spreadsheet to build a LIBOR swap curve. And, if you are doing anything very unique at all, being able to see and follow the whole calculation (and possibly amend or append additional calculations as necessary) is invaluable. When I was trading at two different Wall Street shops, the inflation book’s risk was pulled into my spreadsheets daily and manipulated so that I could understand all of its dimensions. This is, in short, very common.
It turns out that two very important Excel functions in bond portfolio management are PRICE() and MDURATION(). And it also turns out that these functions return an error at negative bond yields. All over the world, right now, as nominal bonds in various countries are trading at negative yields, whole armies of portfolio managers are saying “why is my spreadsheet saying “#NUM!” everywhere? I call this the F9 problem because when you hit F9 in Excel, it calculates your workbook. And that’s when you see the problem.
There is nothing about the price-from-yield formula that is insoluble at negative yields. The price of a bond is simply the sum of the present values of its cash flows. If using a single yield to maturity to price such a bond, a negative yield simply means that the present-value factors become greater than 1, rather than less than 1, in the future. This is odd, but mathematically speaking so what? There is no reason that PRICE() should produce an error at negative yields. But it does.
There is also nothing about the modified duration formula that is insoluble at negative yields. Macaulay duration is the present-value-weighted average time periods to maturity, which (aside from the weirdness of future cash flows being worth more than present cash flows, which is what a negative yield implies) has a definite solution. And modified duration, which is what MDURATION() is supposed to calculate, is simply Macaulay Duration divided by one plus the yield to maturity. While this does have the weird property that modified duration is less than Macaulay duration unless yields are negative, there’s nothing disqualifying there either. So there is no reason why MDURATION() should produce an error at negative yields. But it does.
I don’t know why Microsoft implemented bond functions that don’t work at negative yields, except that, well, it’s Microsoft and they probably didn’t thoroughly test them.
The good news is that inflation-indexed bonds have long had negative yields, so inflation guys solved this problem some time ago. Indeed, it only recently occurred to me that there’s a whole new cadre of frustrated fixed-income people out there.
Let me help. Here are the Visual Basic functions I use for the price from yield of TIPS or other US Treasuries, and for their modified durations. They’re simply implementations of the standard textbook formulas for yield-to-price and for modified duration. They’re not beautiful – I hadn’t planned to share them. But they work. I believe they require the Analysis Toolpak and Analysis Toolpak – VBA add-ins, but I am not entirely sure of that. No warranty is either expressed or implied!
Function EnduringPricefromYield(Settlement As Date, Maturity As Date, Coupon As Double, Yield As Double)
Dim price As Double
accumulator = 0
firstcoup = WorksheetFunction.CoupPcd(Settlement, Maturity, 2, 1)
priorcoup = firstcoup
Do Until priorcoup = Maturity
nextcoup = WorksheetFunction.CoupNcd(priorcoup, Maturity, 2, 1)
If accumulator = 0 Then
dCF = (nextcoup – Settlement) / (nextcoup – priorcoup)
x = dCF / 2
Else
x = x + 0.5
End If
pvcashflow = Coupon * 100 / 2 / (1 + Yield / 2) ^ (2 * x)
accumulator = accumulator + pvcashflow
priorcoup = nextcoup
Loop
‘add maturity flow and last coupon
accumulator = accumulator + 100 / (1 + Yield / 2) ^ (2 * x)
‘subtract accrued int
price = accumulator – WorksheetFunction.AccrInt(firstcoup, WorksheetFunction.CoupNcd(firstcoup, Maturity, 2, 1), Settlement, Coupon, 100, 2, 1)
EnduringPricefromYield = price
End Function
Function EnduringModDur(Settlement As Date, Maturity As Date, Coupon As Double, Yield As Double)
Dim price As Double
firstcoup = WorksheetFunction.CoupPcd(Settlement, Maturity, 2, 1)
price = EnduringPricefromYield(Settlement, Maturity, Coupon, Yield) + WorksheetFunction.AccrInt(firstcoup, WorksheetFunction.CoupNcd(firstcoup, Maturity, 2, 1), Settlement, Coupon, 100, 2, 1)
accumulator = 0
priorcoup = firstcoup
Do Until priorcoup = Maturity
nextcoup = WorksheetFunction.CoupNcd(priorcoup, Maturity, 2, 1)
If accumulator = 0 Then
dCF = (nextcoup – Settlement) / (nextcoup – priorcoup)
x = dCF / 2
Else
x = x + 0.5
End If
pvcashflow = Coupon * 100 / 2 / (1 + Yield / 2) ^ (2 * x)
accumulator = accumulator + pvcashflow / price * x
priorcoup = nextcoup
Loop
‘add maturity flow and last coupon
accumulator = accumulator + (100 * x / (1 + Yield / 2) ^ (2 * x)) / price
EnduringModDur = accumulator / (1 + Yield / 2)
End Function
